The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies

David Larcker is the James Irvin Miller Professor of Accounting at Stanford University.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) imposed a requirement that public companies allow shareholders the opportunity to cast an advisory vote on executive compensation (typically annually). This requirement is commonly referred to as say-on-pay (SOP). Shareholders that disagree with a firm’s executive compensation program can cast anon-binding (or precatory) vote “against” the management compensation program disclosed in the proxy statement for the annual shareholder meeting. Presumably firms with a substantial proportion of negative votes will make appropriate changes to their compensation program.

In the paper, The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies, which was recently made publicly available on SSRN, my co-authors (Allan McCall of Stanford University and Gaizka Ormazabal of the University of Navarra) and I examine the changes that boards of directors make in anticipation of the initial SOP votes and the shareholder reaction to those changes. Since the SOP vote is advisory, boards are under no obligation to make changes pursuant to its outcome. A board may simply wait to see the outcome of the vote before deciding whether changes to compensation programs are warranted. However, if a board anticipates substantial opposition to its executive compensation program and believes that this opposition is costly to shareholders (e.g., because it invites derivative lawsuits, negative press, regulatory scrutiny, or distracts executives and employees), it might rationally take preemptive actions to decrease the probability of receiving negative votes. In such a setting, the board of directors will be interested in anticipating whether institutional investors (who hold the majority of outstanding shares) will vote for or against a SOP proposal.

Many institutional investors rely on proxy advisory firms, primarily Institutional Shareholder Services (ISS) and Glass, Lewis & Co. (GL), for data and analysis to guide their voting choices. Although each institution ultimately controls its own shares, it is not uncommon for funds to rely in whole or in part on the policies and guidelines of proxy advisory firms to inform their SOP voting decisions. As a result, it is possible for firms to substantially decrease the “against” votes on SOP by obtaining a positive recommendation from proxy advisory firms. This can be accomplished by making changes to the compensation program so that its features more closely align with the voting policies of the proxy advisory firms before the proxy statement is released and these firms issue their recommendation. For example, in a recent a survey conducted by The Conference Board, NASDAQ and the Stanford Rock Center for Corporate Governance (2012), over 70% of the director and executive officer respondents indicated that their compensation programs were influenced by the policies of and/or guidance received from proxy advisory firms during their evaluation of SOP. If the policies and guidelines of proxy advisors effectively identify poor pay practices, changes made by boards of directors to align their executive compensation programs more closely with these policies will decrease executive rent extraction and increase shareholder value. However, if proxy advisor voting policies do not identify poor pay practices, changes made to align executive compensation programs with these policies could move compensation contracts away from the optimal structure and reduce shareholder value. The purpose of this paper is to examine the determinants of the SOP voting outcomes (including proxy advisor recommendations), assess whether boards of directors make compensation plan changes that are favored by proxy advisors, and estimate the economic consequences of these decisions for shareholders.

Our tests are based on 2,008 firms from the Russell 3000 index (with fiscal year ends from 6/30/2010 to 3/31/2011) that were required to have a SOP vote under the Dodd-Frank Act. We first show that the proxy advisory firm recommendations can substantially influence the voting tally. For example, a simple univariate analysis reveals that firms that received a negative recommendation by ISS (GL) obtained an average 68.68% (76.18%) voting support in SOP proposals. In contrast, firms that did not receive a negative recommendation from ISS (GL) obtained an average of 93.4% (93.7%) support in those proposals. The difference in voting support between firms that received positive and negative SOP recommendations is consistent with the effect of proxy advisor recommendations documented on other types of proposals (e.g., Bethel and Gillan, 2002, and Cai, Garner, and Walking, 2009). This differential voting effect is even more pronounced when the specific institutions owning shares in the firm historically rely more heavily on ISS recommendations (i.e., institutions are more likely to vote in line with ISS recommendations when there is a disagreement between the voting recommendation of ISS and management). Specifically, for negative SOP recommendations, we find that firms with investors that have an above-median likelihood of voting with ISS exhibit 63.5% support for the proposal, whereas firms where that likelihood is below median exhibit 73.5% support for the proposal.

As a result of their ability to influence SOP votes, proxy advisory firms can induce firms to adopt compensation plan features that they are known to favor (e.g., performance-based equity and elimination of tax gross-ups in change of control plans). For example, General Electric and Disney made substantive revisions to their compensation programs after filing their proxy statements in an attempt to obtain a more favorable voting outcome.While firms rarely discuss the specific role of proxy advisors in making changes to executive compensation in their public filings, reports by business media indicate that these changes were made in response to proxy advisor policies.

Rather than qualitatively focusing on the small number of firms that amended their proxy statements to achieve a positive recommendation from proxy advisors, we examine compensation changes made in the time period preceding the SOP vote that better align the compensation program with proxy advisor policies. We find that these changes are more likely to be observed among firms that expect to receive a negative SOP recommendation in the absence of a compensation plan change and where ISS can influence a substantial number of shareholder votes. Since most executive compensation changes must be publicly disclosed on Securities and Exchange Commission (SEC) Form 8-K, it is possible to precisely estimate the stock market assessment of these decisions by the board of directors. We find that the average risk-adjusted return on the 8-K filing date is a statistically significant -0.42%. Moreover, this effect is unique to 8-K changes in the time period before SOP and similar results are not observed for earlier time periods. As with all observational studies, there are a variety of alternative interpretations of this result. However, we believe that the most plausible conclusion is that the proprietary SOP policies of proxy advisory firms induce the boards of directors to make compensation decisions that decrease shareholder value.

The influence of proxy advisors on SOP is a public policy question that holds special importance for understanding the workings of corporate governance. Institutional investors have a fiduciary duty to take actions that increase shareholder value for their investors, but they can fulfill their duty to vote the shares under their control by relying on independent third-party proxy advisors. While we cannot assess the overall social welfare effect related to the existence of proxy advisory industry, this paper informs this debate by providing evidence on the potential negative economic consequences of proxy advisor SOP policies. Our results raise the question of whether institutional investors should reassess their use of proxy advisory firms when casting their SOP vote.

The full paper is available for download here.

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